Question

United Pigpen is considering a proposal to manufacture high-protein hog feed. The project would require use of an existing warehouse, which is currently rented out to a neighboring firm. The next year's rental charge on the warehouse is $165,000, and thereafter, the rent is expected to grow in line with inflation at 4% a year. In addition to using the warehouse, the proposal envisages an investment in plant and equipment of $1.59 million. This could be depreciated for tax purposes straight-line over 10 years. However, Pigpen expects to terminate the project at the end of 8 years and to resell the plant and equipment in year 8 for $530,000. Finally, the project requires an immediate investment in working capital of $415,000. Thereafter, working capital is forecasted to be 10% of sales in each of years 1 through 7. Working capital will be run down to zero in year 8 when the project shuts down. Year 1 sales of hog feed are expected to be $5.50 million, and thereafter, sales are forecasted to grow by 5% a year, slightly faster than the inflation rate. Manufacturing costs are expected to be 90% of sales, and profits are subject to tax at 25%. The cost of capital is 12% What is the NPV of Pigpen's project? (Do not round intermediate calculations. Enter your answer in dollars not in millions, rounded to the nearest whole dollars.) NPV

Answer 1

Compute the annual depreciation, using the equation as shown below:

Annual depreciation = Equipment cost/ Estimated life

                                 = $1,590,000/ 10 years

                                 = $159,000

Hence, the annual depreciation is $159,000.

Compute the gain on sale of equipment, using the equation as shown below:

Gain on sale = Selling price – (Equipment cost – Accumulated depreciation)

                     = $530,000 – {$1,590,000 – ($159,000*8 years)}

                     = $530,000 - $1,590,000 + $1,272,000

                     = $212,000

Hence, the gain on the sale of equipment is $212,000.

Compute the tax on the sale of equipment, using the equation as shown below:

Tax on sale = Gain on sale*Tax rate

                   = $212,000*25%

                   = $53,000

Hence, the tax on the sale of equipment is $53,000.

Compute the net present value of the project, using MS-excel as shown below:

B Particulars 5 Sales 6 Manufacturing cost 7 Rental charges lost 8 Annual depreciation 9 Profit before tax 10 Tax @25% 11 Profit after tax 12 Annual depreciation 13 Operating cash flows 14 Equipment cost 15 Cash from sale of equipment 16 Tax on sale of equipment 17 Working Capital investment 18 Working Capital recovery 19 Annual cash flows 20 PVIF @12% 21 Present Value C D E F G H к Net Present Value Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 5500000 =(D5*105%) =(E5*105%) =(F5*105%) =(G5*105%) =(H5*105%) =(15*105%) =(J5*105%) =(D5*90% =(E5*90% =(F5*90%) =(G5*90%) =(H5*90% =(15*90% =(55*90%) =(K5*90%) 165000 =(D7*104%) =(E7*104%) =(F7*104%) =(G7*104%) =(H7*104%) =(17*104%) =(J7*104%) 159000 159000 159000 159000 159000 159000 159000 159000 =(D5-D6-D7-D8) =(E5-E6-E7-E8) =(F5-F6-F7-F8) =(G5-G6-G7-G8) =(H5-H6-H7-H8) =(15-16-17-18) =(J5-J6-J7-18) =(K5-KO-K7-K8) =(D9*25% =(E9*25% =(F9*25% =(G9*25%) =(H9*25% =(19*25%) =(19*25% =(K9*25%) =(D9-D10) =(E9-E10) =(F9-F10) =(G9-G10) =(H9-H10) =(19-110) =(19-J10) =(K9-K10) 159000 159000 159000 159000 159000 159000 159000 159000 =(D11+D12) =(E11+E12) =(F11+F12) =(G11+G12) =(H11+H12) =(111+112) =(J11+J12) =(K11+K12) -1590000 530000 -53000 -415000 =-D5*10%) =-(E5*10%) =-(F5*10%) =-(G5*10%) =-(H5*10%) =-(15*10%) =-(J5*10%) =-SUM(C17:J17) =SUM(C13:C18) =SUM(D13:D18) =SUM(E13:E18) =SUM(F13:F18) =SUM(G13:G18) =SUM(H13:H18) =SUM(113:118) =SUM(J13:J18) =SUM(K13:K18) =POWER(1/1.12,0) =POWER(1/1.12,1) =POWER(1/1.12,2) =POWER(1/1.12,3) =POWER(1/1.12,4) =POWER(1/1.12,5) =POWER(1/1.12,6) =POWER(1/1.12,7) =POWER(1/1.12,8) =(C19*C20) =D19*D20) =(E19*E20) =(F19*F20) =(G19*G20) =(H19*H20) =(119*120) =(J19*J20) =(K19*K20) Net Present value =SUM(C21:K21)

The result of the above table is as follows:

B C D E 4 Particulars Year O l 5 Sales Manufacturing cost Rental charges lost 8 Annual depreciation | 9 Profit before tax 10 Tax @25% 11 Profit after tax 12 Annual depreciation 13 Operating cash flows 14 Equipment cost ($ 1,590,000) 15 Cash from sale of equipment 16 Tax on sale of equipment 17 Working Capital investment ($ 415,000) 18 Working Capital recovery 19 Annual cash flows ($ 2,005,000) PVIF @ 12% Present Value ($ 2,005,000) Year 1 $ 5,500,000 $ 4,950,000 $ 165,000 $ 159,000 $ 226,000 $ 56,500 $ 169,500 $ 159,000 $ 328,500 Year 2 $ 5,775,000 $5,197,500 $ 171,600 $ 159,000 $ 246,900 $ 61,725 $ 185,175 $ 159,000 $ 344,175 F G H I J K Net Present Value Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 $ 6,063,750 $ 6,366,937.50 $ 6,685,284.38 $ 7,019,548.59 $ 7,370,526.02 $ 7,739,052.32 $ 5,457,375 $ 5,730,243.75 $ 6,016,755.94 $ 6,317,593.73 $ 6,633,473.42 $ 6,965,147.09 $ 178,464 $ 185,602.56 $ 193,026.66 $ 200,747.73 $ 208,777.64 $ 217,128.74 $ 159,000 $ 159,000 $ 159,000 $ 159,000 $ 159,000 $ 159,000 $ 268,911 $ 292,091.19 $ 316,501.78 $ 342,207.13 $ 369,274.96 $ 397,776.49 $ 67,227.75 $ 73,022.80 $ 79,125.44 $85,551.78 $ 92,318.74 $ 99,444.12 $ 201,683.25 $ 219,068.39 $ 237,376.33 $ 256,655.35 $ 276,956.22 $ 298,332.37 $ 159,000 $ 159,000 $ 159,000 | $ 159,000 $ 159,000 $ 159,000 $ 360,683.25 $ 378,068.39 $ 396,376.33 $ 415,655.35 $ 435,956.22 $ 457,332.37 ($ 550,000) ($ 577,500) $ 530,000 ($ 53,000) ($ 606,375.00) ($ 636,693.75) ($ 668,528.44) ($ 701,954.86) ($ 737,052.60) $ 4,893,104.65 ($ 245,691.75) ($ 258,625.36 ($ 272,152.11) ($ 286,299.51) ($ 301,096.38) $ 5,827,437.02 0.711780248 0.635518078 0.567426856 0.506631121 0.452349215 0.403883228 ($ 174,878.53) ($ 164,361.09) ($ 154,426.41) ($ 145,048.24) ($ 136,200.71) $ 2,353,604.07 ($ 221,500) 0.892857143 ($ 197,767.86) ($ 233,325) 0.797193878 ($ 186,005.26) 22 23 Net Present value ($ 810,084.04)

Hence, the NPV of the project is ($810,084.04)